Insurance is a means by which the risk of loss is contractually shifted from the insured to the insurer. Under this contractual arrangement, the insured pays a premium to the insurer for agreeing to bear some potential loss that the insured faces. Insurance is a very valuable financial tool that helps individuals and legal entities manage the risks they face.
Insurance works best in instances where the definition of loss is clear and the amount of loss is obvious. If a loss is not easy to define or limit, it should not be insured because it will be difficult or impossible to set an appropriate premium. Moreover, it will result in unduly complex coverage terms, disagreements over coverage interpretation, and difficulties in proving and quantifying losses.
To be eligible to receive insurance payments, insurance buyers must be able to prove that they had losses that fit within the coverage definition of their insurance. Losses can be categorized in many different ways such as life, health, property, casualty, etc. More generally, losses can be categorized as being direct or indirect.
A direct loss is a loss where the insured peril is the proximate cause of the loss. For example, the direct loss of a factory due to a fire would be the cost of rebuilding the factory. The indirect losses would be all of the costs associated with the inconvenience of not having a workable factory. Direct losses, such as the physical cost of the buildings in this example, are typically much easier to estimate than indirect losses such as lost income or extra expenses that may result from such an event. Management and employees must spend time trying to recover from this event, and there is always a significant amount of opportunity cost that can never be adequately assessed.
Indirect losses vary in size depending on the specifics of the loss, but they occur with every type of insurable loss. Traditional insurance can cover certain limited types of indirect costs that can be defined and limited such as the loss of income (business interruption) and “extra” or “expediting” expenses that are necessary to return a business to normal after a loss. However, companies and individuals are not insured against many types of indirect losses because these losses are often too difficult to define or tend to be subject to the discretion of the insured. Policyholders often have considerable discretion over indirect losses, making many types of indirect loss impossible to quantify and subject to significant moral hazard.
The subjective and indeterminate nature of these losses makes these types of indirect losses difficult or impossible to insurer. Since indirect losses are becoming an ever larger part of most companies' loss experience, it is no wonder that companies are increasingly frustrated with traditional insurance.